COMMENTARY: Managing the external financing gap, in an unconventional way – Journal
The global economy is going through a perfect storm. The commodity super cycle has led to record prices for key imports. On the other hand, emerging markets are facing capital flight with rising interest rates in the US and EU markets. Emerging economies are facing strains with rising import bills and depleted central bank reserves. Lebanon, Sri Lanka, Suriname and Zambia are already in default.
Pakistan fared better as proactive measures taken by the government averted the threat of default. These include measures to curb imports and fiscal measures to restore the IMF program. Markets are reacting positively to these policy measures; yields on Pakistan’s international sovereign bonds fell sharply to 22% from record highs of 50% in July 2022. The stock market rebounded 7% in August, while the rupee strengthened by more than 10% during the last days of the week.
However, despite the recent improvement in confidence, large medium-term external financing needs continue to cast a shadow over the economy. According to the February 2022 IMF staff report, Pakistan’s external financing needs will remain high – around $35-40 billion per year – over the medium term.
Foreign exchange market stability is crucial to creating an enabling environment for local businesses: attracting new investment, supporting growth and managing inflation expectations. However, given the large external financing needs, the Rupee is likely to remain under pressure as the demand for dollars remains significantly higher than the supply available in the market, at least for the time being.
With overall negative sentiment in capital markets and the downgrading of the rating outlook by international rating agencies, we are effectively shut out of the international bond markets. This leaves the economy too dependent on borrowing from multilateral agencies and bilateral loans from friendly countries. The large funding needs of emerging markets put us in a weak position to negotiate better terms.
Therefore, in addition to ensuring that existing currency flows continue to flow into the country without delay – to avoid any swing in the exchange rate in the market, as has recently been seen – other sources Dollar financing needs to be explored and managed in the medium term to ensure stability.
Lily: The default response
When things are going well, as is currently the case in the foreign exchange market, it is a good time to introduce certain measures so that exporters and senders can be incentivized or coerced into bringing in the existing currency remittances that are blocked. outside the country, and ensure that they continue to arrive without delay and calm the markets.
The central bank needs a better dialogue with the banks, perhaps on a daily basis at the Treasury level, and with the money changers. A better and more aggressive application of discipline is also a need of the hour.
On the other hand, the largest alternative source of external financing in the last 3 years is the Roshan Digital Account (RDA) initiative of the State Bank of Pakistan (SBP) and the Naya Pakistan Certificates (NPC) of the Government of Pakistan. Pakistan. Inflows of approximately $4.8 billion have materialized under this program since September 2020, including $3.1 billion of investments in NPC.
However, entries have slowed sharply in recent months due to unfavorable global market conditions. As global interest rates have risen sharply – the benchmark six-month Libor trading around 3.6% today versus 0.15% at the same time last year – the profit rates offered on NPCs remained unchanged at 5.5% to 7% over various durations.
Profit rates on NPC instruments should be market-based and linked to Libor rates. Even with a 500 basis point spread over Libor, the NPC profit rate of 8.5% will be well below the cost of borrowing in international bond markets, currently at 22%. Urgent attention is needed to maintain the attractiveness of NPC products to induce new inflows and discourage existing investors from exiting.
The second area that needs to be addressed is the large and growing holding of foreign currency assets, primarily cash held by individuals for savings or payment purposes. There is no formal estimate of the size of these farms, but their importance can be assessed from the following data points; the first of which is the size of foreign currency deposits in the banking sector. These are about $5.8 billion today, up from $7.1 billion last year. In 1998, before the freezing of foreign currency accounts, the size of these deposits reached 11 billion dollars.
The second data point is the currency in circulation: the latest data from the SBP shows that it has increased to 8 trillion rupees ($35 billion) and accounts for about 30% of the total money supply in the economy and 40 % of bank deposits.
High currency in circulation is also highly inflationary in nature. In previous bouts of market turmoil, the weak deposit base of banks struggled to meet the government’s deficit financing needs, leading to the printing of money by the SBP.
During periods of exchange rate uncertainty and volatility, many private investors convert their cash into dollars. The reason why investors prefer to hold foreign currency assets “under the mattress” (in cash or in their bank lockers) is the lack of returns offered by commercial banks and the lack of alternative investment opportunities. There is also a reluctance to declare these assets to the tax authorities for obvious reasons.
Therefore, the main objective should be to reduce the currency in circulation, which is only possible with reduced financing needs of the State, either by keeping the debt service at a lower level or by managing the policy rate at appropriate levels (the demand for money in circulation does not lend itself to changes in policy rates), or avoiding new debt by increasing tax and non-tax revenues. We must remember that we must borrow to pay off our existing debt.
The other option is to ensure that the increase in the money supply will be used to meet the main needs of the economy, which at this stage are inflows of dollars – ideally in the form of exports or other sources of investment (bank or other deposits) – to strengthen the currency pool in the country and relieve pressure on government reserves. Today, an investor will only get 0.2pc to 0.75pc on their FX deposits, while large depositors can negotiate a higher rate. By comparison, commercial banks in India offer returns of 2.85% or more on foreign currency deposits. India’s central bank recently lifted the Cash Reserve Requirement (CRR) and Legal Liquidity Requirement (SLR) on additional foreign currency deposits, prompting banks to increase them.
The authors are respectively a former Governor of the State Bank of Pakistan and the Chief Executive Officer of the Bank of Punjab.
This is the first of two articles; the next episode will appear in tomorrow’s edition of Dawn.
Posted in Dawn, August 18, 2022